A perfectly competitive market is defined by the characteristics below. Examples include the agricultural market. To understand how firms work, we first need to define several key words - this will be done in the context of perfect competition below, and then these will be used afterwards in other market structures.

Characteristics of a Perfectly Competitive market
No barriers to entry or exit - this allows firms to quickly and easily enter or leave the industry. Firms that are inefficient are force out, whilst others are forced to keep prices low as there can be so much competition	Many firms in the industry - as a result of no barriers, there are many firms here so that no firm has influence on the market	Firms are price takers - since there is no dominant firm in the market, all firms respond to demand, rather than manipulate it. As consumers have perfect knowledge, there is no way these firms can set their own prices.
Perfect Knowledge - consumers know what the cheapest price is and buy from these firms, forcing others out. This makes all firms price takers.	Homogenous Products - firms produce the exact same product; there is no product differentiation (e.g. coliflowers)	Price Competition - because of homogenous products, firms cannot sell their products on brand loyalty (...it's a cucumber, i don't care who grew it!)

A pure monopoly can be defined as a firm that is the industry; they have 100% of the market share. In real life, monopolies are actually defined as having 25% or more of market share. This enables them to manipulate prices.

Characteristics of a monopoly
Price setter This means that the firm can choose the price to sell their product at. If they choose a high price though, fewer people want it and vice versa. Thus the demand curve - unlike in Perfect Competition - is sloped downwards.	High barriers to entry This means that other firms cannot enter the industry owing to a variety of factors including complex technology, economies of scale, natural barriers to entry, predatory pricing, domination of resources or legal rights. The monopoly is thus the market.
No substitutes available This makes the product very inelastic. The consumer is left with little alternative.	Only one firm The firm is the market as there are no other competitors in a pure monopoly market. Some argue Microsoft were the only firm in their industry ... for a while.

Because monopolies are price setters, this means they can choose whichever price they want. However, we know that price and quantity demanded have an inverse relationship - the more price increases the less quantity is wanted. It's not like the perfectly competitive firm where there can only be one price. As a result, monopolies face downward sloping demand curves, which are fairly inelastic as there are no substitutes

Because of their downward sloping demand curves, Marginal Revenue also slopes downwards. This is because, in order to sell the next unit, the price has to fall. The revenue gained from selling the next unit is less each time (as MR = change in TR/ change in output).

Comparing Monopolies with Perfectly Competitive Firms

1. Quantity - clearly the monopoly produces less in order to profit maximize. By producing where MC=MR, monopolies miss out of the chance of extra revenue, in order to ensure greater profits. Compared to a perfectly competitive firm, less is therefore produced, as the perfectly competitive firm produces where MC=MR=D (as MR and D are equal)

2. Price - these end up higher under monopolies. A monopolies could set price where MC=D, and attain normal profits, but instead they set price where the profit maximizing quantity meets demand. As a result, prices are a lot higher than in a perfectly competitive firm.

3. Profit - because of the high price and low Marginal Costs that monopolies encounter when producing where MC=MR, a large profit is made (red box). This enables research and development and even acts as a barrier to entry. Because MR, D and MC are all equal in perfect competitiion, abnormal profits are not made.

4. Nature of product - both monopolies and perfectly competitive firms offer little variety in products. For monopolies this is because there are no substitutes, but for perfectly competitive firms it is because the products are homogenous to begin with (e.g. cucumbers)

5. Allocative Efficiency (see above diagrams) - we claim allocative efficiency to be producing the combination of desired goods that society wants, at the lowest possible cost. Previously we saw how this can be re-interprated as MC=MB. Where the cost to the producer is the same as the benefit we derive from consuming it. If the price is equal to marginal benefit and marginal cost, then we have a price that everyone is satisfied with. However, this is not the case. Price is always equal to MB (if we pay for the good, then we derive benefit from it), but price and marginal cost are seperated on a monopoly diagram. Too often, marginal cost is lower than the price (or marginal benefit). Thus, only when the two are equal - when P=MC - can we say allocative efficiency has occured. Clearly on our diagram, MC is below P, and thus the producer is gaining above the consumer! Still with us?!

6. Allocative Efficiency through producer and consumer surplus (see below diagrams) - another way of looking at allocative efficiency is through surplus'. Clearly, when compared to perfect competition, consumer surplus falls and producer surplus rises in a monopoly. This is because the price is now higher, meaning less consumers benefit and the more the firm benefits. If one section of society benefits over another, then we cannot be allocatively efficient - as we know from above.

7. Productive Efficiency - this occurs when we are producing the greatest quantity for the lowest possible cost. In other words it is when price is set at the minimum average total cost. We rephrase this as p=minATC.

Characteristics of monopolistic competition
Low or medium barriers to entry - this makes it possible for other firms to enter the industry and steal demand from already existing firms.	Price Competition and Non-Price Competition- firms are in competition with each other but because there are numerous firms and their products are similar, they know they cannot increase price much, otherwise people will just buy their competitors product. They therefore focus instead on non price competition (advertising, branding, loyalty, speciality etc), creating product differentiation.	Numerous Firms- because there are low barriers to entry and abnormal profits can be made in the short run, firms are attracted into these industries.
Similar Product- firms in these industries produce products that are different but very similar - for example sports shoes. They are therefore monopolies in their own small sector but cannot change their product entirely (a shoe is a shoe).	Independence and Interdependence	Imperfect Knowledge

Monopolistic firms are a cross between monopolies and perfect competition. This is because they are monopolies in their own small field of speciality, but have products so similar that they cannot branch away from competitors altogether. Shoes are the best example of this. Aesics are - to a degree - a monopoly is high quality running shoes. But their shoes are not really that different to Nike, Addidas or Reebok shoes.

 

 

Because of this, firms in monopolistic competition find that they cannot really increase their price by much, because if they do, quantity demanded will fall dramatically. For example, if Aesics put the price of their shoes up by 5%, everyone would say "they're a bit expensive, I'll buy Nike instead." So, the best way for these firms to steal demand from each other is not through price - but through non-price competition. Examples of this can be seen in the videos below.

Click here to read an article on just how powerful Nike's branding loyalty (a form of non price competition) can be

 

Demand is key to the monopolistic firm. When we look at the diagram for a particular firm, we can see how they can make abnormal profits in the short run. But in the long run, because there are low barriers to entry, new firms are attracted into the industry. This has the effect of stealing demand from the original firm, thus lowering its demand curve. This will continue to happen until demand and ATC are equal and only normal profits are made, as shown below.

Comparing Monopolistic Competition with Monopolies and Perfect Competition

Looking at the three diagrams, we can see differences in output, profit, productive efficiency, consumer and producer surplus, allocative efficiency and price. This is discussed more at the end of Oligopolies unit.

Characteristics of an Oligopoly
High Barriers to entry - this prevents other firms from joining, keeping profits high	Few Firms- often 3- in the industry (sometimes called 'The Rule of Three')	Mutual Inderdependence and Rivalry
		Competition and Collusion

 

Type of Oligopoly: 1. Cartels

Essentially these are just monopolies that undertake non-price competition. They formally agree to collude (restrict output to keep prices high) in order to maximize profits. Their diagram is thus the same as a monopolies diagram.

As we can see from the diagram, just like with monopolies, cartels produce where MC=MR. However this is easier in theory than in practice. Cartels are notoriously hard to form as:

 

 

 

Type of Oligopoly: 2. Informally Collusive

These are oligopolies that have not officially formed a cartel but have naturally been drawn together. An example comes through

a) Price Leadership - the dominant firm in the industry sets a price and - since the other smaller firms think it is a good price that brings them much revenue too, they put their prices at this level too. The result is similar once more to a monopoly. Firms compete instead heavily on non-price factors

b) Price Cutting and Predatory Pricing - this is when firms in the industry realise it is beneficial to set price at a point which only gives them normal (or very small abnormal) profit. This acts as a fake barrier to entry as competitors think 'well, there's not much money in that business', and so don't join the industry. Similarly, they could collectively set prices below cost level, in order to force other businesses out.

Type of Oligopoly: 3. Non-Collusive

Non-collusive do not get together to fix quantity or price. They have a kinked demand curve owing to the fact that strategic behaviour forms the basis of their decision making. This means that they are most concerned about what other firms will do, if they change their prices. Look at the diagram. We can see the demand curve is 'kinked' (or 'bent'). Why?

The answer lies with strategic behaviour. If - for example - Kelloggs decided to raise their prices, they will first think 'what would Nestle and Post do?' Obviously, Nestle and Post would NOT raise prices, and so most consumers would switch over to their products, leaving Kelloggs with only the consumers that are loyal to the Kelloggs brand. Above Price A demand is thus elastic. They will not therefore raise prices.

But if they decide to lower prices, they would have to again think 'what would Nestle and Post do?'. Well, obviously they would lower their prices too, and so most people would carry on buying the same product they did before. Even a large change in price would not be worthwhile as everyone would do it. Below Price A, demand is thus inelastic. They will not therefore drop prices. Prices remain 'sticky downwards'.

This kind of thinking is linked to 'Game Theory'.

	Price	Profit	Output	P.Efficiency	A.Efficiency	C+S Surplus	Product
Perfectly competitive	low	normal	highest	yes	yes	maximized	same quality
Monopoly	highest	abnormal high	low	no	no	high producer, deadweight loss	depends on R&D
Monopolistic	varies	short-run abnormal	fairly low	no	no	deadweight loss	higher quality
Oligopoly (non-collusive)	high	abnormal high	low	no	no	deadweight loss	depends on type

 

Price Discrimination is the practice of charging different prices to different consumers, without incurring any changes to the unit cost of production of your goods. It attempts to further maximize a firm's profits. There are 3 types: Perfect, Second Degree and Third Degree.

Before a company can practice price discrimination it must identify the following conditions:

* It must be able to seperate consumers according to their elasticities for a product (you charge a high price for someone with a high PED and a low price for someone with a low PED)

*It must ensure that consumers either optionally buy in to price discrimination (e.g. 2nd or 3rd degree) or are unaware it is happening.

* It must make sure consumers cannot sell-on their products (if they could, why would anyone buy the higher price?)

* It must make sure they have a downward sloping demand curve (if they are in perfect competition, they cannot price discriminate as they are price takers, where consumers have perfect knowledge, and thus would never buy at different prices)

Perfect Price Discrimination

Second Degree Price Discrimination

Third Degree Price Discrimination